Joint venture

Not sure why joint ventures seem to go in waves, but our China lawyers have been getting more than usual lately. I suspect it has something to do with increased flexibility on the Chinese side as a reaction to recent fears regarding China’s economy.

In any event, our recent joint venture work has gotten me to thinking about what it takes for a China joint venture to succeed. Based on both our own observations and also on what we hear from others, we view the following four things as key to achieving a China joint venture that works.

1. Make ownership and control clear. Make ownership and control of the joint venture explicit from the very start. Most managers of Chinese companies see the joint venture company as their own property. They are not sensitive to issues of control that arise from percentage ownership interests. It is important to insist that the Chinese side recognize and formally agree to any structure that will result in the foreign partner to a joint venture exercising control over the venture, particularly of day-to-day operations. The foreign party should never assume the Chinese side understands the implications of a joint venture arrangement that flows entirely from purely technical legal rules. If the Chinese side feels it has been tricked or duped into signing away its rights, it will likely take action to “correct” the situation.

2. Do not expect a 51% ownership interest in a joint venture to provide effective control. 51/49 joint ventures are generally a mistake in China. The Chinese see 51/49 joint ventures as fundamentally no different than a 50/50 joint venture and they tend to view legal control afforded by 51% ownership as unfair. As a result, in ventures between Chinese participants where one side clearly intends to exercise control over the venture, a 60/40 or a 70/30 ownership structure is typically used.

Foreign investors that use a 51/49 joint venture structure should not count on their control of the board of directors as giving them control over the joint venture company because the board actually exerts very little control over the operations of the company. The managing director/representative director and the general manager of the company have the actual power to dictate the operations of the company and can act — and usually do — with little or no supervision from the board of directors. Therefore, if the foreign party intends to exercise actual control, it must structure the joint venture so it has the power to control and appoint both the managing director and the general manager of the joint venture company. These persons must be directly responsible to the foreign partner and not to the Chinese partner. If it is not possible to exercise direct control over these positions, then control over the board of directors is of little or no benefit to the foreign partner.

3. Do not proceed with a joint venture formed on a weak or uncertain legal basis. It is very common to find business arrangements in China that are of questionable legality under Chinese law. Going forward with a joint venture in the face of potential illegality may mean that the foreign party cannot enforce its rights in the joint venture because the Chinese courts will not enforce the terms of an illegal joint venture. Because of this, it is a standard strategy for the Chinese side to convince the foreign side to go forward with such questionable ventures. For the Chinese side, there is little or no risk. If the venture fails, the Chinese side has the advantage of having received funds from the foreign venture. If the venture succeeds, the Chinese side simply takes over. If your China attorney is telling you that your joint venture is illegal and your putative joint venture partner is urging you to go ahead anyway, listen to your attorney.

4. The foreign party must actively supervise or participate in the day-today management of the joint venture. If you are not actively involved in the operations of your China joint venture, the Chinese side will likely begin to feel as though it is doing all the work with the reward going to absentee owners. This produces resentment and the desire to take action to restore the “fairness” of the arrangement. Also, when not actively supervised, the Chinese side of the JV will frequently manipulate the JV for its own benefit. Active participation in the management of the joint venture and effective supervision of senior management can prevent such issues from arising. Active day-to-day participation in the management of the joint venture company by at least one senior manager appointed and controlled by the foreign partner is usually required.

No guarantees of success if you do the above, but an almost certain guarantee of failure if you don’t.

As regular readers know, both my co-blogger (Steve Dickinson) and I have written extensively on China Joint Ventures, both here and elsewhere. This is because we find them fascinating, mostly because they are so difficult to make work. Here are some of our previous writings on joint ventures in China that focus on when to enter into a joint venture and how to make one work:

What distinguishes the joint ventures that work from those that don’t?

According to a recent McKinsey article, Avoiding blind spots in your next joint venture, “even joint ventures developed using familiar best practices can fail without cross-process discipline in planning and implementation.” According to McKinsey’s own studies, JVs succeed only around half the time, even though JV best practices are well known:

When we interviewed senior JV practitioners in 20 S&P 100 companies—with combined experience evaluating or managing more than 250 JVs—they estimated that as many as 40 to 60 percent of their completed JVs have underperformed or failed outright. Further analysis confirmed that even companies with many joint ventures struggle, even though best practices are well-known and haven’t changed for decades. In fact, most of our interviewees endorsed several that have long been the gold standard for JV planning and implementation: a clear business rationale with strong internal alignment, careful selection of partners, balanced and equitable structure, forethought regarding exit contingencies, and strong governance and decision processes.

Why do so many joint ventures fail even when the Western company knows what it should be doing to make it succeed? Mostly a failure to follow best practices either initially or later on down the road when the company’s enthusiasm for the joint venture has waned:

Our interviewees suggest that in the rush to completion, even experienced JV managers often marginalize best practices or skip steps. In many cases, the process lacks discipline, both in end-to-end continuity and in the transitions between the five stages of development—designing the business case and internal alignment, developing the business model and structure, negotiating deal terms, designing the operating model and launch, and overseeing ongoing operations. Moreover, parent-executive involvement often declines in the later stages. Finally, many JVs struggle with insufficient planning to respond to eventual changes in risk. Such lapses, even in the early stages of planning, create blind spots that affect subsequent stages and eventually hinder implementation and ongoing operations. We’ll examine each of these issues, along with the approaches some companies are taking to deal with them.

The “rush to completion” is usually due to pressures to “get the deal done quickly.” How can this be remedied? “Companies must find ways to balance the pressure for speed with the demands of planning a healthy joint venture—especially allocating their time and resources in line with the potential for value and impact.”

I tend to agree.

If I look back at the China joint venture deals in which my law firm has been involved (and lets throw in the Russian joint ventures and the Vietnam joint ventures that we have drafted as well because why not?), I would say that there is a direct correlation between the time and planning and even difficulty of reaching a joint venture deal and the eventual success of the joint venture. Put simply, the joint venture deals that were completed in one month are less likely to be standing today than those that took three months.

Why is that?

Joint ventures are incredibly complicated. Just by way of one simple example, who is going to be in charge of hiring, you the American company or the Chinese company? The quick answer is usually the Chinese company, because the Chinese company certainly knows better who to hire in Dalian or in Wuhan than you do. But then what’s to stop the Chinese company from hiring 100 of its relatives or from charging mediocre people for jobs at your joint venture? And if it does that, where do you think all of your profits are going to go? So now that you realize the importance of your having some say in hiring, what say are you going to require? Certainly you do not want to do the hiring, but do you want veto rights? Should you be limited in the number of potential employees that you have the right to decline? What about firing employees? Certainly your position will be different on managers than janitors. Speaking of janitors, are you going to want to limit the number of janitors the JV can hire? The issues on control can be endless, and this is just one of thousands of issues that joint venture partners might resolve before they ink a deal.

Yet the more issues on which the putative joint venture partners agree before the joint venture is formed, the less room there is for arguments and disputes and wrenches being thrown in the works after the joint venture is formed.

So next time you are ready to kill someone (i.e., your China lawyer) during the third month of your trying to work out a joint venture deal, just remember that every day of delay is probably increasing your chances of the joint venture generating you money, as opposed to falling apart.

Just read a CNN article entitled, China offers big risk, bigger reward. The article quotes me and a nice range of other attorneys on what it takes for foreign companies to succeed in doing business in China — from a legal perspective. I really like the article, but I have a beef with its title.

If I had written the title, it would have been something really like, “China offers big opportunities, but hey, it’s gonna be difficult and it isn’t nearly as cheap as it used to be.” I am just not sure China is all that risky for foreign companies. I say this because my “sense” is that well over 90 percent of my law firm’s clients that do business in China or with China succeed at it and because every AmCham survey I can remember essentially says that American companies in China are thriving. Is it difficult doing business in China? Of course it is. Just the mere fact that it is a foreign country (make that a very foreign country) with a different business culture, language, and laws guarantees that will be the case. Is it risky? Well, yes, in that it is a foreign country with a different business culture, language and laws, all of which increases the likelihood of something going wrong. But is it physically dangerous? No. Are foreign countries at any real risk of having their assets appropriated by the government? No.

You want risky? Let me tell you about risky. Many years ago, a very good client of ours was offered the shrimp farming concession in a small African country. THE shrimp farming concession. Like for the entire country, which meant a huge amount of easily caught shrimp. We worked with our client on various aspects of the deal and the most conservative numbers showed that the return on the investment would be astronomical. Like about 300% starting in the first year. One big problem though was that none of the last three foreign companies that had been given the same concession had lasted even one year without the government taking everything and unceremoniously booting them out. The government sought to assure us that it had good reason all three times but in the end, our client deemed the deal too risky.

Bad things do happen to good foreign business in China, but as compared to many other emerging markets, China is relatively tame.

But the article itself does an excellent job setting out the core legal issues foreign companies face in China and conveying that dealing with those issues is not going to be easy or cheap. It starts out talking about a young entrepreneur who found it difficult forming a WFOE because, among other things, he had to first prove that he had office space and a commercial address. The article said this first meant that this entrepreneur had to make a “significant upfront investment, with no guarantee of [WFOE] approval.” This is only sort of true in that many landlords in China these days will agree to what we call a tentative lease. Under such a lease (which we do literally all the time for our clients), the foreign putative tenant need only start paying if the WFOE is approved. Landlords typically agree to this and we have never had a WFOE rejected because of this.

It then quotes me as saying that “many” wait for a year to have the paperwork approved. This too is only sort of true. We have never had a situation where it has taken anywhere close to a year for our WFOE paperwork to get approved; but we have had situations where it has taken our clients a year or so to complete the WFOE registration process because the foreign company seeking the WFOE was simply not well prepared from a business side to do everything it would take. For instance, a typical slowdown is when the foreign company has trouble finding an appropriate space to lease. For more on the issue of leasing space for a WFOE in formation, check out the following:

The article then rightly notes that “hiring staff, conducting training, avoiding corruption and protecting intellectual property are some of the biggest challenges they face.” I completely agree with this, in that probably 80 percent of what we do for foreign companies that are already in China relates to one of these items.

It then talks about the need to find the right hire/right partner — someone , who “can bridge West with East, and East with West.” This is so true. In fact, I went to lunch with a good friend/client yesterday and much of the conversation was him telling me how difficult it was going to be for him to find the right general manager for a new business he has been working on in China. Like everyone else, he seeks someone who understands both the China side and the Western side and can deal with the people on both sides and actually knows the specific business. Those people are always going to be few and far between. Janet Carmosky just wrote an excellent article for the China Business Review on this issue, entitled, What a China Team Needs.

The article then (quite wisely) notes how “business in some industries — media, banking and energy, for example — can only be done through a joint venture with a local Chinese partner.” In other words, these businesses cannot be 100% foreign owned and therefore they cannot be done as a WFOE; foreign companies therefore typically get involved in these industries in China via a joint venture.

The article then relays how “corruption carries some of the biggest risks for businesses looking to break into China” and how it is “common practice” in some industries “for firms to give generous gifts and entertain business partners with lavish meals, and companies may lose an edge if they don’t follow suit.” Unfortunately, this is true and as a foreign company you will need to decide whether you are going to risk jail time for yourself and your employees by violating the law. Needless to say, our advice is always not to do it and to do everything you possibly can to make sure that ethos is made clear and enforced throughout your company. We constantly are working with our clients to help them avoid corruption.

The article then addresses the importance of protecting intellectual property and rightly suggests that foreign companies “register trademarks or patents before entering China.” It also mentions some non legal steps for protecting IP, such as “setting up offices or plants in different locations, and only taking the most essential core technology overseas.” For more on registering trademarks in China and the timing of that, check out the following:

BBC News just came out with a story entitled, How to win in China: Top brands share tips for success. The article starts out ranking the most successful foreign brands in China, as based on a massive Millward Brown survey on how “meaningful,” “different” or “salient” foreign brands were “and how easily they came into consumers’ minds.” “Thirteen of the top 20 brands are from the US, two from Germany, two from France, one from Italy and one from the Anglo-Dutch conglomerate Unilever. South Korea’s Samsung is the only Asian brand on the list.” No surprise, KFC comes out on top.

More interesting for me, however, was that eleven of the top twenty foreign brands in China (Coca-Cola, McDonald’s, Nike, L’Oreal, Apple, Samsung, Adidas, Armani, Omo/Unilever, VW and KFC) gave the lowdown on what it takes for building your brand in China.

The article starts out by noting the following fairly obvious facts about Chinese consumers:

“Chinese consumers once valued low prices above any other factor when making choices. But a mix of higher living standards and falling trust in local brands means people are looking to international brands more.”

Foreign brands are getting a boost from China’s growing middle class.

There are big opportunities in China “for international brands to make their move as consumers start to value quality and experience as much as price.”

It then looks at what it is going to take for foreign companies doing business in China to get their brand out, and again the points are fairly obvious, but helpful nonetheless:

1.Get in early. The article notes all of the top twenty brands have been in China since at least 2000. In other words, it takes time to build your brand and the sooner you start doing so, the better. There are definitely advantages to beating your competitors to the hearts and minds of the Chinese consumer. The Chinese market is changing quickly and many of the companies are learning to keep up.

2. Change as the China market changes. The China consumer market is not static and you need to move with it, not against it. “Everyone is learning about how they need to work with changing social attitudes and continuous aspirational trade-ups, even the Chinese themselves, ” according to McDonalds.

3. The China market is not the same as your home market. “Never assume what works for your mature markets will work for China. Success comes for those who stay relevant to the needs of the Chinese consumer.”

4. Know your market. The article notes how Unilever went into China with its Omo detergent after having gained “a fully researched understanding of the behaviors of consumers.” and how “Nike is developing products around Chinese habits and sports.” Interestingly, it also discusses how when Georgio Armani first went into China, he painted the door of his Beijing store red “as he thought it would appeal more to his customers. Now Armani says he doesn’t really change his offering in China from other markets as the customers want the Western style he sells internationally.” This is really one of the toughest issues a company can face. Does it tout that it is foreign and stand by that without changes, or does it bend to the local market and provide China with a different product than elsewhere? For more on this glocalization issue, check out the following:

5.Go big or go home. The article does not quite say this, but it implies that once you start doing business in China, you should not hesitate to build out your operations so as to extend your brand. It sets out some “staggering” numbers regarding some of the leading brands, including the following:

KFC has 4,400 restaurants in 850 cities and will add another 700 this year

McDonald’s plans to open ten restaurants a week and will by 2015 have invested another $4bn expanding in China.

Apple is doubling the number of stores in China in the next two years.

China is Volkswagen’s biggest market with a third of its global business, and it has seven new production plants in the pipeline.

6. There’s money to be made outside Shanghai and Beijing. “Many of the brands … stressed the importance of looking beyond the coastal cities of Shanghai and Beijing to the staggering growth and new consumers in cities across the country.” Half of the 800 stores Adidas opened in China last year were so-called “lower-tier” cities.

7. There is no “one China.” China is large and varied and what works in Shanghai may not work in Qingdao. The article notes how “Samsung and L’Oreal tailor their approach in China to different regions. Adidas “has found very different attitudes in the North and the South of the country but says even in inland cities, consumers are increasingly looking to buy aspirational foreign brands.”

8. Have good boots on the ground. “Running a business in China is difficult to do from outside the country, and many of these multinationals tell us that their success is built on finding the best Chinese talent and joint venture partners” and “hiring and then training the best local talent will help” you better understand your Chinese customers.

One of the themes of this blog for years has been that China is making things tougher for foreign businesses by increasing the strength of its business laws and by stepping up its enforcement of them against foreign companies. We hear that the same thing is happening to Chinese domestic companies, but starting from a much lower base.

But virtually whenever we write about this, someone leaves a comment or emails us to say that we are making this up to scare people.

The American Chamber of Commerce in China recently came out with a survey of its members and hidden and far more publicized fact that 78% of the respondents said they had been hacked was that only 28 percent of respondents view China’s investment environment as improving, down from 43 percent just last year. In other words, China is getting tougher on foreign businesses doing business in China. Running a foreign business in China has never been easy, but it has in the last few years gotten even harder still.

So what can or should you do? One, consider whether it makes sense to move some (or in very rare cases) all of your operations somewhere else. In the last two years, we have experienced an uptick in our clients expanding beyond China (Vietnam and Thailand and returning home have been especially popular lately) or at least considering doing so. Two, consider not entering China at all by way of actually setting up shop to do business there. At least think about how you can profit from China’s growth without having to set up and operate a Joint Venture or a WFOE there. Selling into China via a distributorship relationship or a licensing deal are just two obvious ways that have grown rapidly in popularity over the last couple of years. For more on these two methods of “entering” China, check out the following:

A couple of years ago, we did a post on FICEs, entitled, The China FICE — Foreign Invested Commercial Enterprise. The reason we did that post then (and the reason we are doing this post now) was to clear up common confusions regarding FICEs, which really are nothing more than a subset of Wholly Foreign Owned Entities (WFOEs) and Joint Ventures (JVs). In that post, we sought to explain FICEs as follows:

A FICE is a WFOE that is authorized to engage in wholesale and/or retail trade. The approval requirements for these sorts of entities tend to be stricter than for a manufacturing or service WFOE. Additionally, approval of a FICE usually must come at the provincial level, not the local level. There are some provinces that do not even accept FICE applications. Shanghai and Beijing have the authority to approve the establishment of a FICE, and for that reason, most FICE operations are formed in those two cities.

Foreign Invested Enterprises (FIEs) mostly consist of Wholly Foreign Owned Entities (WFOEs) and Joint Ventures (JVs). All Foreign Invested Enterprises must set out the nature of their business during the licensing phase of the entity registration process. There are all sorts of possible categories, including Regional Headquarters, Service, Purchasing Center, Research and Development Center, Investment/Holding Company, Service Company, Manufacturing Company and Foreign Invested Commercial Enterprise (FICE).

In the end though, a FICE is nothing more or less than a type of WFOE or JV.

With the growth of the Chinese consumer, we are dealing more and more with FICEs and I want to get out there exactly what they are even though I do not like the term FICE because it tends to lead to more confusion than clarity. A FICE is just a type of WFOE or JV that engages in certain types of business in China. So what are those “certain types of business”? The general answer is retail and wholesaling and franchising.

Saw a link today on our China Law Blog Group on Linkedin (which you really should join if you have not yet done so — 7,000+ members and we keep it entirely spam-free!) to a talk by Kent Kedl, entitled, The Five Biggest Challenges to Doing Business in China. Kent is the Managing Director, Greater China and North Asia, for Control Risks. I have known Kent since forever and trust me when I assure you that he knows China business as well as anyone. The below is our typed rendition of Kent’s talk, cleaned up a bit for written consumption:

The number one challenge for companies investing in China is finding out what their motivation is. Early on everyone was really interested in China because of its big population. There is a very big difference between a population and a market and companies need to really find out why they are going into China and why they are doing what they are doing. Many times when we’ve worked with companies that get into trouble for having found the wrong partner or or for going into the wrong industry, it’s because they really weren’t quite sure why they were going into China in the first place. Companies need to make sure everyone agrees why they are doing what they are doing. Everybody needs to agree that this is what they want to do because China is for the long haul. It’s not a nine month mini project. You’re going to be there for a long time. It’s going to go up and down and you have to have the staying power to really succeed there.

The second big issue in China is a lack of information. Deng Xiaoping spoke of how the way forward in China is going to be like crossing the river by feeling for stones. This is a really good image because when you cross arushing river you do not know if its safe and you so you have to keep using your foot to test it. And that’s China. You are going to have to make decisions without complete information and that’s very difficult for some companies to do.

Number three is kind of similar to number two. In China, there is always a story behind the story. There’s a person behind the person. It’s never what you see on the front end. It is partially related to cultural issues. For 5,000 years there has been this inside outside orientation to much of Chinese culture and as an outsider you are shown a certain view and as an insider you are shown a certain view. And there are various levels of being an insider or outsider. Again when you are trying to do business with a company or a person, you should find out where this person is from, where this company is from. What is their history? How did they become who they are today? How did they get their money? Who is behind them? There is always someone sitting behind them, and not in a nefarious way. You are not talking to some puppet or shadow. There is just a level of complexity to Chinese business and to Chinese society that is important to take into account. We advise companies to never stop asking questions.

The fourth challenge to foreign investors in China is understanding the role of the government. Obviously the Chinese government is very involved in business. About 15 years ago, the Chinese government made a statement that it was going to get out of the business of being in business and there was then a wave of privatizations of Chinese State Owned Entities (SOEs). Then a number of years later, the government came out and said, “yes we want to divest, but we also want to maintain some control and some influence in key sectors,” like the oil and gas sector, the transportation sector, and the media, among others. Even some of the private companies that have completely privatized have government influence behind them, particularly smaller companies in smaller towns outside the big cities. The local government is very interested in the success of these companies and they want to make sure that those companies remain a revenue and employment base. So if you are doing a deal with such a company — particularly if you are trying to acquire or do a joint venture with one of them, it’s absolutely critical to find out what the local government thinks.

The final thing is that having one definition for what it means to do business in China is impossible. It is very different to do business in Beijing versus Shanghai or Shanghai versus a tier two or tier three city. It is very different to do business in the consumer sector versus the industrial sector versus whatever. China is such a complex place and as business people our goal is to reduce complexity. We want to reduce risk by understanding the complexity and then packaging it up so we can identify. China resists that at every turn and in the vast majority of crisis that we help our clients with arose because they brought someone from Beijing or Shanghai to try and solve a problem out in one of the tier three or tier four cities and the people there treated that person, a Chinese person from Shanghai or Beijing, like a foreigner or worse than a foreigner. They just didn’t accept them locally. So all business in China is local and all locales can be quite different from each other.

The below comes from an article I wrote a couple years ago for a manufacturing magazine. I am reprising it today after having just communicated with a company that could sorely have stood to have read it. The point here is that it is possible to do business in China safely, simply by following some basic due diligence rules.

Whether it is cynicism or realism, I am becoming increasingly willing to blame “the victim” of China business problems. I am convinced that nine times out of ten, when bad things happen to good people who do business internationally, it is the “good person’s” fault. Like all lawyers who work with China, I have a ready set of horror stories, which I rotate depending on the occasion, but usually include one or more of the following (modified slightly to protect the guilty):

The guy who “invested” $500,000 into a China business because the owner of the Chinese business was allegedly the son of a five-star general. One of my law partners suggested to this investor that he instead use the money to fly himself and my law partner to Vegas (this was before Macao got so big) and put the money on red. As my partner put it, the chances of the client recovering his money there were much greaterand it would be a lot more enjoyable. This guy went ahead and invested the $500,000 and lost every bit of it. He then wanted us to sue the “son of the general” on a contingency fee basis, but we would not have taken on that case for a 150% contingency.

The guy who bought a million–dollar condo in Shanghai under his girlfriend’s name because he believed that foreigners were not allowed to own real property in China. His girlfriend then left him and claimed he had given her the condo as a gift. The guy wanted us to sue the girlfriend but we demurred, saying that we just did not like a case where our client would need to stand in front of a Chinese judge and explain that he had put the condo in his girlfriend’s name so as to avoid (what he believed was) Chinese law. And here’s the kicker. When he bought this condo for his girlfriend, he could have purchased it in his own name, no problem! His girlfriend had lied to him about Chinese real property ownership laws

The countless people who call my firm after having sent tens of thousands of dollars (sometimes hundreds of thousands of dollars) to someone in China for a product that never arrives. Eventually the person and “company” to whom they sent the money disappears. We have never taken one of these cases because we deem them pretty much hopeless.

The US company that used its joint venture partner’s local Chinese lawyer (what was this company thinking?). The Chinese lawyer drafted up agreements that involved the American company giving its critical technology to the joint venture permanently, without getting any real influence or control in the venture. This is an amalgamation of probably half a dozen poorly formed joint ventures in which we have been called in. You can find out more regarding this sort of Chinese joint venture deal in When in China Trust Everyone.

Approach the company as a potential customer does. “You want to see what the China side customers see. Fraudulent companies have far less confidence that they can fool a Chinese company in their industry than they do about fooling a starched shirt analyst. Moreover, they’re usually less willing to take legal risks in their home market (China) than they are in the United States.” In other words, look to see how the Chinese company with whom you are interested is treated by other Chinese companies.

Take all company-provided introductions with a grain of salt. “When companies set up meetings or conversations between you and their suppliers or customers, take them with a grain of salt….In a country where a lot of managers earn less than $500 per month, it’s not hard for an unscrupulous company to buy someone’s loyalty for the duration of a meeting or phone call. You should instead rely on your own networks to help you understand the company and industry. If you don’t have those networks, you unfortunately shouldn’t be making investment decisions in China by yourself.” I completely agree.

Try to construct your own fraud scenario. “At some point in evaluating every investment, you should stop and ask yourself how you could have staged everything you’ve been shown or done with the company. It is good for American investors to practice this mentality because it makes us less credulous. More importantly, this kind of thinking makes clear how surprisingly simple measures (e.g., switching factory signs before you arrive, painting old machinery) can be so effective in fooling the credulous investor.” I absolutely love this advice and I urge everyone to follow it.

Forget about the paper. Focus on the operations. “In today’s world where you can buy a competent color printer for less than $200, it’s hard to understand why investors place so much faith in bank statements, invoices, and contracts. China’s deal making world abounds with stories of forged bank statements and other documents leading to disastrous deals. Unfortunately, most auditors apply the US audit playbook in China – reviewing and taking documents at face value….Instead, you have to look at the operation itself. How much does the output seem to be, how much material is moving into and out of the factory, does the office seem to be a hive of activity, how many employees can you count, what is the square footage of the facilities? These are all basic questions one should concern themselves with during site visits. And it pays to visit two to three (or more) times — a good fraudster can put on a show, but they’re unlikely to be able to do it the same way each time. Watch for the subtle differences. Ultimately if you cannot find a good way to measure the company’s sales or productivity (as in the case of a service company), you should think carefully about proceeding with the investment.” I completely agree with the advice to put the Chinese company’s operations under a microscope, but I completely disagree with the advice to ignore the paper, as I discuss more fully below. I advocate putting the paper under a microscope as well.

Speak with competitors. “Competitors with real businesses can usually tell you one of two things about a fraudulent competitor — either that it’s obscure (sometimes the “competitor” is hearing about the company for the first time); or, that they know it’s a fraud. Many competitors will be reluctant to speak openly at first about a fraudulent competitor if they know you’re a potential investor in the fraudulent company. However, if you’re a potential customer who is shopping around for a vendor, it can be a different story.” This is excellent advice, but one should also take the views of competitors with at least a bit of salt.

Do not delegate. “A lot of experienced China investors have stories about subordinates who colluded with a target company to attempt (and sometimes succeed) to defraud the investor. Be attuned to the dichotomy between the investment funds at stake and the income/wealth of the people on whom you rely for judgment.” Very true. At least half the time when my firm has been brought into a fraud situation, we have to ask ourselves whether the “trusted subordinate” was incredibly stupid or in on the fraud.

The seventh rule (my addition) is to put the documents you receive under a microscope because the fraudulent company will nearly always make some mistake in its documents. In my career, I have caught the following, all of which threw up massive red flags:

Company claimed to have a multi-million dollar account at a non-existent bank;

Company documents showed a subsidiary in the Marshall Islands, yet always spelled the country as Marshal Island. It had no such subsidiary;

Company claimed to have a branch office in a particular city, yet its documents on that branch office (including supposed government documents) put that city in the wrong province;

Company claimed to be bringing in twice as much product as physically possible on a particular ship;

Company claimed to have been shipping out product on a particular ship that did not exist during the first few years when the product was allegedly being shipped;

Company claimed to have won an IP lawsuit in a country’s Supreme Court (they produced the Supreme Court’s decision and everything), but there had never been such a case.

Bill Bishop at the DigiCha blog did a great post entitled, Do You Know Where Your China Stock CFO Lives?setting out China company (mostly publicly traded) warning signs. The post talks about two Chinese companies, Longtop Financial and Sino-Forest, that publicly trade in the United States and have been under scrutiny for alleged improprieties. Both have Canada-based CFOs even though the bulk of their operations are in China. Bishop posits that these companies may have hired foreign-based CFOs as “China fraud beards.”

Company went public through an OTCBB Transfer or other ways of back-door listing;

Company name starts with “China” [unless they are state-owned they cannot register a company in China starting the word “China”];

The products are sold in China, but there is minimal Chinese-language information about those products;

The business defies common sense;

The underwriter, audit firm and accounting firm are second tier and/or have a track record of missing frauds (like Deloitte China).

Bishop adds a sixth item to the list, that “the CFO does not live in the same city as corporate HQ and is not a regular presence there.”

I like Bishop’s admonition not to invest in a business that defies common sense. Yes, that is pretty basic, but in many ways it is the key. It is not too dissimilar from the advice I gave in the When in China Trust Everyonepost mentioned above:

First off, THINK. That’s right, think. Secondly, do not do anything you would not do in any other country. Just because your Chinese partner and/or your Chinese partner’s lawyer tell you this is how things are in China does not mean you have to believe them and it certainly does not mean you have to abandon your common sense.

One more thing to do before you invest or, in some cases, even do business with a Chinese company: get their official corporate records from the official Chinese government sources. We have of late been doing this rather frequently for our clients and though it is neither inexpensive nor easy, it can be incredibly enlightening in that it usually goes far beyond the information provided by the basic company search firms.

The China company search firms typically provide only a fairly basic list of information, such as the names and addresses of those involved with the company and its registered capital. In addition to not being terribly complete, the information from these search firms is of dubious provenance. How did they get the information? Can we be sure they looked at the entire file? We know the files are only supposed to be open to lawyers. How did they obtain access? When did they review the documents? Last year’s documents may be of no help at all.

We strongly suggest that you seek out the full SAIC (State Administration for Industry and Commerce) file on the Chinese company about whom you are seeking information.

In our experience, the SAIC only opens its file to licensed Chinese attorneys. Everyone else is turned down. The Chinese licensed attorney must go in person to the SAIC office, review the file, and make copies in the office. It is our understanding that the Chinese companies investigated through the SAIC will know they are being investigated.

These SAIC forays usually give us massive amounts of documents in Chinese, which we then either translate for our clients or, more typically, summarize. They usually contain all sorts of key economic data on the company as well.

In our first post, we listed out the following ways to “employ” someone in China without forming an entity there:

1. A foreign company could have its proposed employee hired by a Chinese company and then pay the Chinese company the equivalent of the Chinese employee’s wages and taxes, plus an administrative fee. The problem with this is that if the “employee” is not going to be doing at least some work for its Chinese employer, it probably is not legal and if the foreign company gets caught, it may never be allowed to conduct real business in China again. If the “employee” does not actually do work for the Chinese company, it is nothing more than an attempt to get around the laws that require foreign companies with an employee in China to be a legitimate Chinese entity (be it a WFOE/WOFE, a Joint Venture/JV, or a Representative Office).

And if the foreign company’s goal is to have its “own person” on the ground in China, how much of “its own person” is someone employed by and paid by another? And how this foreign company protect its trade secrets from the Chinese company? There are definitely situations where this can work, but not every situation will.

Then there are all the issues for the Chinese company, which is likely going to have to lie to the Chinese government as to why it is receiving monthly foreign currency payments.

UPDATE ON THIS OPTION: Since writing the post, we have received calls from a foreign company that was caught doing this and then effectively kicked out of China and from a couple other foreign companies that were doing this whose Chinese company stopped going along with this program out of fear of getting caught. This has led us to conclude that this is, at best, a very temporary remedy, if even that.

2. A foreign company can hire the Chinese “employee” directly and just wire that “employee” his or her paycheck every month. Years ago, this sort of arrangement was pretty common, but it is becoming far less so as word is spreading that the Chinese government and tax authorities are very much on to this scheme and are quashing it. The problem with this set-up is that the foreign “employee” is at some point going to have to explain to the Chinese government why it is that he or she is monthly depositing foreign currency into his or her bank account and why no taxes are being paid on it.

In our last post, we noted the following big flaw with this sort of arrangement: “We have received a number of calls in the last year from companies seeking our help in keeping their Chinese ’employee’ after they were told by their ’employee’ that the existing relationship must be discontinued. We told them that their best solution would be to form a China WFOE, but that we were very concerned about their WFOE application being rejected because of what they had already done.”

UPDATE ON THIS OPTION. Since we did our last post, we have heard from many more foreign companies that have gotten into trouble with the Chinese authorities for having employed this option. Perhaps more importantly, we are finding that the trend is for Chinese prospective employees (particularly those with a high level of experience or skill-set) to flat out refuse this sort of arrangement.

3. The third and maybe best option (at least from a legal standpoint) is for the foreign company to have its Chinese “employee” form his or her own domestic Chinese company and then simply contract with that Chinese company for the services it is seeking from this Chinese person. This is going to require a fair amount of initiative by the Chinese employee and the downside of this is that when all is said and done, your client has an independent Chinese company out there with which it is conducting business, and not an employee.

UPDATE ON THIS OPTION. We are unaware of anyone ever having tried this option as every foreign company has either deemed it too risky from the perspective of protecting its intellectual property or the prospective employee has simply been been unwilling to go through this convoluted process for the “job.”

4. Have your potential employee hired by a China-based staffing agency. Under Chinese law, Representative Offices are not allowed to directly employ anyone; they must do so via a third party staffing agency. Because of this, there are plenty of such staffing agencies in China and up to a few years ago, many of them were (for a somewhat reasonable fee) willing to hire someone for a company based overseas. Today, we know of only one such agency that will do that for foreign companies without their own entity in China (be it a WFOE or a Rep Office) and that agency charges a 15% monthly commission on the salary to do so. On top of that, come July 1, 2013, all of this will almost certainly be impossible as on that date, China’s labor law will be revised to make third party hiring for anything but “temporary, supplementary and backup jobs” illegal. For more on this, check out this article, entitled, “Newly amended PRC Labor Contract Law imposing stricter control over the use of seconded employees.”

At this point, I am not sure that the one remaining agency that will employ someone for a foreign company without an entity in China will remain willing to do so, but I doubt it.

For years, China has sought to force foreign companies seeking to hire in China to form a company in China. It appears that come July 1, it will have achieved this goal, which really is part of two much larger goals of increasing its tax revenues, particularly from foreign companies, and improving the lives of its working citizens. There is not going to be any going back on any of this. If you want someone working for you in China, you are going to need to form an entity — almost certainly a WFOE — to accomplish this.

One of the things we are always preaching on this blog is the need to first ask whether what you are proposing to do in China is legal or not. I am always telling of how a company once contacted us, bragging about the huge amount it had spent on market research and proudly proclaiming it to have revealed a “huge need” for a Western company in a particular industry. My knee-jerk response to which was that I did not even realize that foreign companies were now allowed in that industry. Ten minutes of research soon revealed that they were not and this company ended up never going into China, wasting the money it had spent to prove it would have done well there.

We were recently contacted by a very much on the ball investement research company regarding the legality of setting up shop in China as a Wholly Foreign Owned Entity (WFOE). We did some quick research (so quick, in fact, that we did not even charge for it) and our initial response was as follows:

The most recent version of China’s Catalogue of Foreign Investment provides the following:

Restricted Industry:

Article 9.3: Market Research (restricted to joint ventures)

Prohibited Industry:

Article 6: Social Survey

We view this as meaning that foreign companies cannot engage in company research as a WFOE. However, many companies do it by creating a service WFOE stating that it will assist foreign investors in investing in China. Then what they really do is market research. As long as you do get caught, it does not matter. If you do get caught, the risk of any real problem is pretty low. Unless that is that you say something in your research that offends the wrong person.

We actually have represented a number of market research firms operating in China as WFOEs. Heck, we have represented some of them on contracts with large Chinese SOEs and with large multinationals. But these companies mostly interview 3,000 people about their thinking on handbags; they are not doing in-depth research on Chinese publicly traded companies, which spin-off massive amounts of money to important people.

So here are some of your options:

1. Do a “consulting” or a service WFOE and run the risk.

2. Do it as a Joint Venture. Find someone in China to do this with and set it up so that you effectively control it.

3. Operate from Hong Kong and fly people in.

The company chose to wait.

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About China Law Blog

We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.